UNFAIR VALUE

The simple answer is that they are unlucky.Everyone comes into this universe with a destiny set in stone. We just live the script.

Ha ha…I was kidding. There is no such thing as luck.

Years ago, when I was a speculator with the mistaken belief that I was investing, I used to go to my broker's office quite often. In his office, there were always some day-traders who used to sit there the whole day and 'invest' in stocks on margin. Among these people was an old man with thick spectacles, a septuagenarian. I liked him because among this boastful gang of traders, he was a quiet guy. One day he asked me, what is the price of Reliance (He couldn't even read the prices blinking on the screen due to poor eye sight)? I said "124". He placed an order with the broker to buy 500 Reliance stocks and then turned to me and said, "ab ye neeche jaayega" [now this will go down]. I was a little shocked at the air of inevitability in his words yet I remained quiet. Later that day when Reliance fell to Rs 112, he smiled at me and said "dekhaa!" [See, I told you so!]. The stock kept falling and fell to Rs 107 and the old man asked the broker to book losses and sell the stocks. He turned to me and said, "Ab bech diya, ab ye upar jaayega" [Now that I've sold it, it will shoot up]. It happened. The old man muttered, "hum to gawaane ke liye hi baithe hain" [I sit here all day simply to lose money].

It was an unnerving experience for me. I was a novice yet I could see something disastrously wrong with the way people invest. Their investing strategies were suicidal. The probability of them winning was significantly less than 50%.

Over the years, I have understood why some people always lose. In primary markets, they lose because the promoters know more about their business than the small investors. They sell stocks in an IPO when they know that they will be able to sell at a price higher than the intrinsic value. The small investor doesn't have the courage or foresight to hold on to these stocks for the long term. When the prices correct, the small investors sell. That is the time when you see buybacks, open offers and delisting proposals. It's an unfair game and the investors have significant chances of losing money. The 'conservative' small investors, who invest only in IPOs, lose money mainly due to this reason.

In secondary markets, the big problem is that most investors lack the capability to make decisions under uncertainty. Such decision making involves attaching probabilistic weightage to possible outcomes. This is part of high school arithmetic, the only prerequisite for you to invest safely. Probability is full of some very counter intuitive results. Try out few simple problems, guess the correct answer before you calculate, and calculate before you read on.

Q1 : What is the chance that there at least two kids in a class of 40 whose birthday will fall on the same day. Make a guess.(a) 0.6% (b) 90% (c) 12% (d) 1.1%

Q2 : Every day a 1,000 lottery tickets, of Rs 100 each, are sold which have unique 3 digit numbers from 000 to 999. The ticket matching the randomly generated 3 digit number gets a prize money of Rs 1 lakh. You have Rs 1 lakh of savings (and no other assets) and you decide to buy one ticket daily till you win the lottery. What are the chances that you will go bankrupt?(a) 36.7% (b) 0.4% (c) 9% (d) 50%

The answers (given later in this article) will surprise you when you try them for the first time .If you are not able to grasp the risk and to analyze the attractiveness of returns while keeping the risks in mind, you are ill equipped to invest. The markets are much more complicated than the simple mathematical problems I gave you. You may get yourself in situation where loss becomes a mathematical certainty.

Consider this.I give you a bet where you need to put some money on the table and you'll have to roll a dice marked with numbers 1 to 6 on 6 faces. If you get 1 or 6, your money will be tripled. If you get 2, 3, 4 or 5, your money will be halved. Would you play this bet?You should. The odds are stacked in your favor and if you play for sufficiently large number of times, you will win. And I'll give offer to roll the dice at least 30 times. I want to prevent you from putting 1 Rs bet after you have tripled your money. Hence I add another restriction, "You need to bet all the money in your wallet, including profits, on each bet".

Are you game for this?

While you think about this, let me recount a story. One day, I was sipping coffee with a friend at my office on the third floor. The room had glass walls. My friend asked,"If I come running and slam against the glass, will it break?""I can bet it won't. Name the odds you want". I said"Hmm, it isn't that strong. It CAN break," he said.I replied, "Doesn't matter, If it doesn't break you'll pay, if it breaks, you are dead."

This is what I call a lose-lose bet. The bet I gave you before this story is also a lose-lose bet. How? Suppose you start with 1,000 Rs. You are likely to win one out of three games. In that typical three game set where results are win – lose – lose, your 1,000 Rs will go to 3,000 – 1,500 – 750.In 30 times, you win 10 times and lose 20 times. At the end of 30 games you will have 5,000* 310) / 230) = Rs 281.

You are expected to lose 62% in just 30 games but you won't be alone. People do this day in, day out in stock markets.

It is important to note that few additional constrains can make a statistically profitable bet a sure-shot losing bet. In investing, we work under these constraints. We have limited money to invest and a limited number of years left before we die. This changes the equation completely.You cannot invest in marginally profitable bets. You need to ensure a big margin of safety. You cannot bet on highly rewarding bets which have low probability of success. If you do, your time on planet earth may run out before you strike gold.

Coming back to the questions I had asked.The answer to Q1 is b, 90%. The implication is that when you are exposed to multiple improbable yet fatal risks in a stock, your loss may become inevitable.

The answer to Q2 is a, 36.7%. If you bet on an event which has low chance, it may not occur in your lifetime. If you pay for each of these bets, you can get broke before you get lucky. If an event usually occurs once in N times, it has 36.7% probability of not occurring in N times (for large N).[For mathematically inclined: The value of (1 – 1/n)n tends to 1/e where e is Euler's number, 2.71828 1828. You may want to read Jakob Bernoulli's seminal work on probabilities. He figured out the probability of an event happing exactly k times in n independent trials is (nCk)pk(1-p)n-k where p is the probability of the event happing in one trial]

The biggest mistake people make on probabilities is that if something has 50% chance, it doesn't mean it's going to happen half the time you try. Probability doesn't work on small sample sizes. The lesser you chance of success, the more number of tries you need to break even.The net results from a set of investments depend not only on the number of successes and failures but also returns from each success and failure. That forces you to take into account the expected value, the probability weighted total of the money. This is another unintuitive number because a positive expected value does not guarantee success in small number of trials.

A related mistake is to bet something really important to get something that is unimportant. You are saving for years for a house you want to buy. Then you realize that you are still falling short by 10 lakhs. You decide to gamble in the market to get the extra money. You should never risk something important for a few extra bucks.

Warren Buffett in a talk to MBA students explained this in a very interesting way. Talking about failed hedge fund, Long Term Capital Management which was managed by really experienced and knowledgeable people (including 2 Nobel laureates), he said:

"To make money that they didn't have and didn't need, they risked what they did have and did need. And that's foolish. That's plain foolish. If you risk something that's important to you, to get something that is unimportant to you, it just does not make any sense. I don't care what the odds are 100:1 to succeed or 1000:1 to succeed. If you hand me a gun with a thousand chambers or a million chambers, and there is a bullet in only one chamber, and you say ‘Put it on your temple , how much do you want to be paid to pull it once?', I'm not gonna pull it. You can name any sum you want, it doesn't do anything for me. On the upside it does not make a difference and the downside is fairly clear.

Finally, you will always be better off believing in Murphy's laws than believing in a God that takes care of your interests. When things go wrong, they sometimes surprise you by their interrelations, creating what Munger calls the lollapalooza effect. In the recent times, you would see an almost synchronized movement of the various asset classes. When the economy is down, stocks, real estate, commodities, everything falls in tandem. To make matters worse, the employment levels fall and people lose jobs. Sometimes hyper inflation and high interest rates add to the misery. When such all round attack happens on your financial fortress, it may seem like a cosmic conspiracy against you but deep down you would see that a single factor may be at the root of all troubles.

Prudence demands handling such situations upfront. As a matter of policy, I don't invest in the stocks of my employer because if the company gets into trouble, I'll lose my investment along with my job. This is not a far fetched scenario. At Satyam, many employees had almost their entire networth invested in the company because their only investment was through the stock options that they got. When the company went through crisis, they were under serious risk of losing everything including their sleep.

You may wonder if I'm equating investing to betting when using terms like probability. After all, in investing you never know the probabilities. The answer is that estimating rough probabilities and having an intuitive understanding of the risks and of returns is essential in the field of investing. You don't know the intrinsic value of the company either. You invest a stock when it is available below your calculated guess on the value of the company, leaving a margin of safety. Similarly you have to estimate the risk of individual stock and that of your diversified portfolio.

You have to be wary of lose-lose situations and you have to be intelligent enough to spot a win-win deal. The biggest profits I've earned are in situations where I was taking absolutely zero risk – something that runs counter to the belief that you need to take more risk to get more returns. Almost all the mistakes I've made in the beginning of my investing career, were preventable if I had done my homework before jumping to buy.

There is a tendency among losers to attribute all of their profits to their brilliant mind and all their losses to bad luck. If you bet on a 50-50 event and lose you are not unlucky. Even if you bet on something having 99% chance of success and lose, I'll have to investigate further to call you unlucky. It is possible to lose despite such high odds if success gives you measly returns and loss takes everything away. If you keep betting your entire money on such a bet, you will definitely lose.

So the correct answer to the question "why do some people always lose money?" is not bad luck but the quote from Douglas William Jerrold: